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CONTENT

Module 1

Topic Pg. no.

1.1. Basic Concepts of Money - meaning, functions and classification
1.2. Role of money in capitalist, socialist and mixed economies
1.3. Monetary standards : Metallic and paper systems of note issue
1.4. Determination of money supply and credit creation
1.5. Money Multiplier

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Module 1
1.1 BASIC CONCEPTS OF MONEY - MEANING, FUNCTIONS AND
CLASSIFICATION

1.1.1Meaning of Money:
Money is a concept which we all understand but which is difficult to define in exact terms.
Money is anything serving as a medium of exchange. Most definitions of money take
‘functions of money’ as their starting point. ‘Money is that which money does.’ According to
Prof Walker, ‘Money is as money does.’
This means that the term money should be used to include anything which performs the
functions of money, viz., medium of exchange, measure of value, unit of account, etc. Since
general acceptability is the fundamental characteristic of money, therefore, money may be
defined as ‘anything which is generally acceptable by the people in exchange of goods and
services or in repayment of debts.’
1.1.2 Functions of Money:
In general terms, the main function of money in an economic system is “to facilitate the
exchange of goods and services and help in carrying out trade smoothly.” Its basic
characteristic is general acceptability. Functions of money are reflected in the following well-
known couplet:
“Money is a matter of functions four A medium, a measure, a standard, a store.”
Thus conventionally money performs the following four main functions, each of which
overcomes one or the other difficulty of barter. Medium of exchange and measure of value
are primary functions because they are of prime Importance whereas standard of deferred
payment and store of value are called secondary functions because they are derived from
primary functions.
 Money as the Medium of Exchange:
Money came into use to remove the inconveniences of barter as money has separated the act
of purchase from sale. Medium of exchange is the basic or primary function of money.
People exchange goods and services through the medium of money. Money acts as a medium
of exchange or as a medium of payments. Money by itself has no utility (except perhaps to
the miser). It is only an intermediary.
The use of money facilitates exchange, exchange promotes specialisation Increases
productivity and efficiency A good monetary system is, therefore, of immense utility to
human society. Money is also called a bearer of options or generalised purchasing power
because it provides freedom of choice to buy things he wants most from those who offer best
bargain.
 Money as a Unit of Account or Measure of Value:
Money serves as a unit of account or a measure of value. Money is the measuring rod,
i.e., it is the units in terms of which the values of other goods and services are measured in
money terms and expressed accordingly Different goods produced in the country are
measured in different units like cloth m metres, milk in litres and sugar in kilograms.
Without a common unit, exchange of goods becomes very difficult Values of all goods and
services can be expressed easily in a single unit called money Again without a measure of
value, there can be no pricing process. Without a pricing process organised marketing and
production is not possible. Thus, the use of money as a measure of value is the basis of
specialised production.
The measuring rod of money is also indispensable to all forms of economic planning.
Consumers compare the values of alternative purchases m terms of money Producers also
compare the values of alternative purchases m terms of money. Producers compare the
relative costliness of the factors of production in terms of money and also plan their output on

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the basis of the money yield. It is, therefore, highly important that the value of money should
be stable.
 Money as the Standard of Deferred Payments:
Deferred payments are payments which are made some time in the future. Debts are
usually expressed in terms of the money of account. Loans are taken and repaid in terms of
money.
The use of money as the standard of deterred or delayed payments immensely
simplifies borrowing and lending operations because money generally maintains a constant
value through time. Thus, money facilitates the formation of capital markets and the work of
financial intermediaries like Stock Exchange, Investment Trust and Banks. Money is the link
which connects the values of today with those of the future.
 Money as a Store of Value:
Wealth can be stored in terms of money for future. It serves as a store value of goods
in liquid form. By spending it, we can get any commodity in future. Keynes places great
emphasis on this function of money. Holding money is equivalent to keeping a reserve of
liquid assets because it can be easily converted into other things.
People therefore normally wish to keep a part of their wealth in the form of money
because savings in terms of goods is very difficult. This desire is known as liquidity
preference. Clearly money is the best form of store of value. Wheat or any other product
which will command a value cannot be stored for a long period.
Another Function ‘Liquidity of Money’ is added these days. Money is perfectly liquid.
Liquidity means convertibility into cash. Thus, the ability to convert an asset into money
quickly and without loss of value is called liquidity of asset. Modern economists are laying
stress on liquidity of money.
Since, by definition, money is the most generally accepted commodity, it is also the
most liquid of all resources. Possession of money enables one to get hold of almost any
commodity in any place and money never locks a buyer. It is this peculiarity which
distinguishes money from all other commodities. A preference for liquidity is preference for
money.
Money, thus, acts as common medium of exchange, a common measure of value, as
standard of deferred payments and a store of value.
1.1.3.Classification of Money :
Some of the major leads under which money has been classified are as follows: (i)
Full bodied Money (ii) Representative Full-bodied Money and (iii) Credit Money.
Money can be classified on the basis of relationship between the value of money as money
and the value of money as a commodity.
Broadly, money can be classified as: Full Bodied money; Representative Full bodied
money; and Credit money.
 Full bodied Money:
Any unit of money, whose face value and intrinsic value are equal, is known as full
bodied money, i.e. Money Value = Commodity Value. For example, during the British
period, one rupee coin was made of silver and its value as money was same as its value as a
commodity.
 Representative Full-bodied Money:
It refers to money which is usually made of paper. The value of representative full-
bodied money is much higher than its value as a commodity. It is accepted as money as it can
be conveniently used for carrying out transactions.
Such a type of paper money is 100% backed by metallic reserve of gold or silver and is
redeemable at the option of the holder. For example, in case of convertible paper receipts, a
person can exchange the amount stipulated on the paper receipt for equal value of gold.

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Two Kinds of Representative Money:

A. Convertible Paper Money:
It refers to the currency notes which are freely convertible into full-bodied money
(gold or silver) at any time at the option of the holder. However, 100% backing of gold or
silver is not desired as all the notes in circulation are not simultaneously presented for
conversion.
B. Inconvertible Paper Money:
It is that kind of paper money which cannot be convertible into full-bodied money at
the option of the holder. However, it circulates and commands value as its issue is regulated
by a responsible government. This money does not have any backing of standard coins or
bullion. Indian one-rupee note is a good example of inconvertible paper money.
 Credit Money:
Credit money refers to the money whose intrinsic value (as a commodity) is much
lower than its face value, i.e. Money Value > Commodity Value. For example, face value of
Rs 100 note is Rs 100, but we would get a much lower value if we sell the note as a piece of
paper. Credit cards, bank deposits are other examples of credit money.
The various forms of credit money are:
(a) Token coins:
These refer to small coins of various denominations, which are issued to facilitate
day-to-day requirements of the people. All Indian coins, like those of Rs 10, 5, 2 or 1, are
token coins since their value as money is more than value of metal contained in them.
(b) Representative Token money:
It is 100% backed and is fully redeemable in some commodity such as gold or silver.
It is generally in the form of paper and market value of what is actually offered is less than
value printed on paper notes.
(c) Circulating promissory notes issued by central bank:
These are currency notes issued by Reserve Bank in India. These include all currency
notes of denominations like Rs 1,000, Rs 500, Rs 100, etc. Each promissory note contains the
words, “I promise to pay the bearer the sum of Rs…………. “, and is signed by the Governor
of India. The commodity value of a promissory note is much less than its money value.
(d) Demand Deposits in bank:
Deposits are claims of creditors (depositors) against bank. These deposits can be
withdrawn from the bank or transferred from one person to another by issuing a cheque. Such
deposits do not have backing in terms of any bullion (gold or silver). The commodity value of
a cheque is much lower than its money value. Demand deposits are very convenient for
making transactions of huge amounts as they remove the risk of carrying large amounts of
cash.
1.2. ROLE OF MONEY IN CAPITALIST, SOCIALIST AND MIXED
ECONOMIES
1.2.1 Money in a Capitalist Economy:
Money has been of great help to consumers as it has given them ready command over
goods and services with additional facility of its being divisible into smaller units.
It enables them to distribute their limited income on different goods and services in a manner
that they can get maximum satisfaction.
Further, it has made possible the best use of scarce resources. Money has brought
expansion in consumer demand thereby laying the foundation for a broad extent of the
market.
According to Prof Robertson, “The existence of a monetary economy helps society to
discover what people want and how much they want…and so to decide what shall be

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produced and in what quantities and to make the best use of its limited productive power.
And it helps each member of society to ensure that the means of enjoyment, to which he has
access, yield him the greatest amount of actual enjoyment which is within his reach.”
In a system of free enterprise, the decisions as to how much and what kind of goods shall be
produced are guided by the price-mechanism, which operates through money only. Price-
mechanism brings about not only a redistribution of factors of production as between the
industries, but also directs the use of resources into most desired channels.
Money has great importance to producers especially in a capitalist economy
characterized by large-scale specialisation and division of labour. It has enabled the producer
to organize his production in a most economical manner and spared him the botheration’s of
barter system, under which good deal of time and energy had to be wasted in bartering the
goods and services produced.
A large-scale producer is able to pay labourers wages in the farm of money, which
they accept in the confident expectation of being able to obtain with these wages the things
which they need. Producers and businessmen are concerned, while planning their future
production, with the cost of production, and selling prices along with profits—all calculated
in terms of money. According to H.G. Moulton, “Money is an indispensable pre-requisite to
the assembling of the concrete instruments of production.
The businessman uses money…… to purchase materials for the construction of his
factory. He uses money…in buying the supplies…and he employs money as a means of
attracting to his organization the requisite labour force and administrative officials.
Further, it facilitates advance payments of various types. The producer has to pay to the
labour force much before he gets the final product and sells it. Labour is, thus, supported by
means of advance payments made in the form of money wages. Similar is the case of loans
made by one businessman to another businessman, which is rendered easier by the presence
of money. Mobilization of saving from the general public would have been impossible but for
money.
It is altogether an indispensable tool for development of the credit market. Lending
and saving in the last resort means lending and saving of real goods and services which
money commands, when one man lends, it means that he shows his willingness to transfer
command over goods and services to another and expects to be repaid at a future date—all
this having been made possible by the use of money. Again, a modern state no more receives
taxes in the form of goods and services but in the form of money. Money has made capital
more mobile.
Money is a vehicle of social reform and a cure of economic maladies. It is held by
some that life will not be worth living without money. The importance of money in the
smooth functioning of society can be realized when we recall to our minds the bad effects of
disorganized monetary system as in an underdeveloped economy, where everything gets
confused the moment money ceases to work smoothly.
According to Dr Marshall, the growth of money economy made possible the growth
of present day liberal and free enterprise system. Even housewife willingly takes the help of
money in arranging her budget so as to derive the maximum benefit from the expenditure of
money. Even in the non-financial sphere, money has assumed importance as it measures both
things and persons.
According to H. Davenport, “All economic comparisons are made in money terms,
not in terms of beauty, or of artistic merit or of moral deserving.” Is one a great artist or
leading advocate or a famous singer or a learned teacher or a celebrated author will depend
upon what his earnings in terms of money are! It would not be out of place to say that money
valuations pervade all our thinking in a capitalist economy.
1.2.2 Money in a Socialist Economy:

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Some writers have expressed the opinion that money in a socialist economy has no
role to play. They feel that it is ‘carry over’ from capitalism and a true socialist economy
should bring about an abolition of money and credit, thereby sparing the economy of the evils
of money. They further believe that in a socialist economy the means of production are
owned and operated by the state for the common good, sources are employed in an optimum
manner and goods are distributed amongst the consumers under the direction of the state.
Hence, pricing process and therefore, money has no role to play in such an economy.
Money is regarded as a superficial element in such an economy— where economic activities
are planned, controlled and executed by the state the use of money can be given up
altogether. Marx and Lenin express themselves against money.
According to Marx money helped the exploitation of labour. In his opinion, an ideal
economy is a natural economy where there is no medium of exchange like money and goods
are exchanged freely against goods and this is quite possible in a socialist economy.
However, the attempts made to abolish money through extensive direct controls and free
distribution of goods failed after the October Revolution of 1917 and Lenin admitted in 1921
that communism without a process of money circulation will not be possible. Trotsky also
asserted the inevitability of money in socialist planning. As such the use of money was
retained despite the intensive totalitarian planning of the USSR.
Such a contention, however, cannot be upheld. The modern socialist economies like
USSR, Yugoslavia, Poland and even China have all made use of the pricing process and
hence money both in theory and practice. History of Russian economic development tells us
that Lenin had to introduce free market in retail trade through price mechanism to restore
order in an otherwise dislocated economy. He confessed that a socialist economy could not
do away with the use of money in the socialist calculation and control.
Trotsky also expressed the view that no commercial accounting was possible without
the use of a monetary unit. Even in the present day Soviet Russia, workers receive wages in
exchange for their services in terms of money which they spend on consumer’s goods. The
experience in Soviet Russia proved that the abolition of money payments would seriously
affect incentives and reduce efficiency of labour. Prof. A.P. Lerner is of the opinion that a
socialist economy cannot function smoothly without money. He says, “Without money, it is
impossible for an economic system of any complexity to function with any reasonable degree
of efficiency.”
According to Prof N. Halm, “Even if the aims of production should be determined by
a dictator, the allocation of resources according to these aims would have to be the result of
the working of pricing process by means of which it is possible to compare the usefulness of
the available resources in different fields of employment.” Thus, a socialist economy is also a
monetary economy, as it has the impact of money in one form or the other, though its role
may be minor at times.
While money is a master in a capitalist economy, it only acts as a servant in the
socialist economy. Money has been found necessary in such an economy because of its
technical functions, such as, means of payment, standard of value, unit of account, etc. The
question of right priorities and equal distribution of goods produced are rendered possible
through price-mechanism, which in turn, acts through money.
1.2.3 Money in a Mixed and Developing Economy:
Money plays no less significant role in a mixed and a developing economy. A mixed
economy is characterized by the prevalence of public sector and an equally important private
sector which plays varying degrees of role. In England, the public sector serves to stabilize
and regularize the imperfections in the economy and aims at providing services, which the
private sector cannot provide without incurring huge social costs (like the public utility
service).

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In other words, in mixed economy of the type found in England, public sector plays
the regulatory role of compensatory spending and pump priming. But in India, public sector
plays a more dynamic and important role in the planned economic growth. The public sector
in India has been given an important place in different Five-Year Plans of development.
Prices and money, therefore, play an important part in a mixed and developing economy in
determining the volume of output and employment in the private sector, as it is solely guided
by the profit expectations calculated in terms of money. Further, in a developing and
expanding economy, which has adopted ‘Mixed Economy’ as the pattern of development,
more and more money is needed for the rapid monetisation of the non-monetised sector of the
economy.
Moreover, money will influence not only the relative shifts in the distribution of
income in an expanding economy, but will also determine the allocation of limited resources
to different sectors of the economy. The role of money in a developing and mixed economy
assumes greater importance as money becomes an important factor of development and
capital formation.
A developing economy is characterized by an increase in national and per capita
income. It is an economy in motion in which stagnation lags behind and dynamic forces of
growth are constantly at work to break through the old values and institutions. In the
unorganized sector of such an economy, subsistence farming holds sway over the commercial
farming and not much margin is left for exchange. The use of money is, therefore, at best
limited. But as the economy expands, agriculture gets commercialized and urban influence
penetrate into the rural sector, money is increasingly used in the day-to-day transactions,
thereby lubricating the wheels of production.
In the rural areas, where it was used primarily as a store of value to fulfill the desire
for high liquidity of the people and was kept in the form of gold till now, it assumes a more
active and dynamic role by serving as a standard of deferred payments, a unit of account, a
measure of value and a medium of payment.
Thus, the unorganized rural sector of the developing economy, which had hitherto
remained unaffected by monetary influences, now comes under the purview of money and
through it the rate of interest, thereby affecting income, output and employment.
In a developing mixed economy (like India), the public sector is affected by the use of
money partly because goods and materials have to be purchased from the private sector at
rising prices, thereby raising the cost of production of various productive units in the public
sector.
Again, if the rate of interest shows a tendency to rise on account of inadequate supply
of money (funds), the public sector may have to pay more on loans borrowed from the public
and the burden of the public debt may be increased. Thus, the role of money in a developing
and mixed economy is more complex, for its true and real nature is not revealed during
transition and, therefore, lot of control is needed so as to avoid its evil effects without
affecting the tempo of development.
1.3. MONETARY STANDARDS : METALLIC AND PAPER SYSTEMS
OF NOTE ISSUE
1.3.1 Metallic Standard:
Under metallic standard, the monetary unit is determined in terms of some metal like gold,
silver, etc. Standard coins are made out of the metal. Standard coins are full-bodied legal
tender and their value is equal to their intrinsic metallic worth. The important thing to note is
that to be on a metallic standard a country must keep – (a) its monetary unit at a constant
value in terms of the selected metal, and (b) its various types of money convertible into the
selected metal at constant values.

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Metallic standard may be of two types: Monometallism and Bimetallism.

1. Monometallism:
Monometallism refers to the monetary system in which the monetary unit is made up or
convertible to only one metal. Under monometallic standard, only one metal is used as
standard money whose market value is fixed in terms of a given quantity and quality of the
metal.
Features of Monometallism:
Essential features of monometallic standard are given below:
 Standard coins are defined in terms of only one metal.
 These coins are accepted as unlimited legal tender in the discharge of day-to-day
obligations.
 There is free coinage (i.e., manufacture of coins) of the metal.
 There are no restrictions on the export and import of metal to be used as money.
 Paper money also circulates, but it is convertible into standard metallic coins.
Types of Monometallism:
Monometallism can be of two types:
a. Silver Standard:
Under silver standard, the monetary unit is defined in terms of silver. The standard coins are
made of silver and are of a fixed weight and fineness in terms of silver. They are unlimited
tender. There is no restriction on the import and export of silver. The silver standard
remained in force in many countries for a long period.
India remained on silver standard from 1835 to 1893. During this period, Rupee was the
standard coin and its weight was fixed at 180 grains and fineness 11/12. The coinage of the
Rupee was free and people can get their silver converted into coins at the mint. Similarly,
silver coins could be melted into bullion.
Silver standard lacks universal recognition as compared to gold standard. There is greater
instability of both internal and external values of money under silver standard because silver
price fluctuates more than that of gold. Thus, as far as the metal is concerned, gold is
preferred to silver in most of the countries.
b. Gold Standard:
Gold standard is the most popular form of monometallic standard; the monetary unit is
expressed in terms of gold. The standard coins possess a fixed weight and fineness of gold.
The gold standard remained widely accepted in most of the countries of the world during the
last quarter of the 19th century and the first quarter of the 20th century.
The U.K. was the first country to adopt the gold standard in 1816. She was also the first to
abandon this standard in 1931. Germany adopted the gold standard in 1873, France in 1878
and the U.S.A. in 1900. Gradually, gold standard disappeared from different countries and
finally it was completely abandoned by the world by 1936.
Gold standard is the most popular form of monometallic standard. Under gold standard, the
monetary unit is expressed in terms of gold. The standard coins possess a fixed weight and
fineness of gold. The gold standard remained widely accepted in most of the countries of the
world during the last quarter of the 19th century and the first quarter of the 20th century. The
U.K. was the first country to adopt the gold standard in 1816.
She was also dying first to abandon this standard in 1931. Germany adopted the gold standard
in 1873, France in 1878 and the U.S.A. in 1900. Gradually, gold standard disappeared from
different countries and finally it was completely abandoned by the world by 1936.
Gold standard has been defined differently by different monetary economists. According to
D.H. Robertson, “Gold standard is a state of affairs in which a country keeps the value of its
monetary unit and the value of a defined weight of gold at equality with one another.”

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According to Coulborn, “The gold standard is an arrangement whereby the chief piece of
money of a country is exchangeable with a fixed quantity of gold of a specific quality.”
In the words of Kemmerer, “a gold standard is a monetary system in which the unit of value,
in which price and wages are customarily expressed, and in which the debts are usually
contracted, consists of the value of a fixed quantity of gold in an essentially free gold
market.”
Merits of Monometallism:
Monometallic standard has the following advantages:
i. Simplicity:
Since only one metal is used as a standard of value, monometallism is simple to operate and
easy to understand.
ii. Public Confidence:
Since the standard money is made of a precious metal (gold or silver), it inspires public
confidence.
iii. Promotes Foreign Trade:
Monometallism facilitates and promotes foreign trade. Gold or silver standard is easily
acceptable as an international means of payment.
iv. Avoids Gresham’s Law:
Monometallism avoids the operation of Gresham’s law. According to this law, when both
good as well as bad money exist in the economy, bad money tends to drive out of circulation
good money.
v. Self-Operative:
It makes the supply of money self-operative. If there is surplus money supply, the value of
money will fall and the people will start converting coins into metal. This will wipe out the
surplus money, thus creating a balance.
Demerits of Monometallism:
The following are the demerits of monometallism:
i. Costly Standard:
It is a costly standard and all countries, particularly the poor countries, cannot afford to adopt
it.
ii. Lacks Elasticity:
Monometallism lacks elasticity. Money supply depends upon the metallic reserves. Thus,
money supply cannot be changed in accordance with the requirements of the economy.
iii. Retards Economic Growth:
Economic growth requires expansion of money supply to meet the increasing needs of the
economy. But, under monometallism, scarcity of metal may create scarcity of money supply
which, in turn, may hinder economic growth.
iv. Lacks Price Stability:
Since the price of the metal cannot remain perfectly stable, the value of money (or the
internal price level) under monometallism lacks stability.
2. Bimetallism:
Bimetallism is a monetary system which attempts to base the currency on two metals.
According to Chandler, “A bimetallic or double standard is one in which the monetary unit
and all types of a nation’s money are kept at constant value in terms of gold and also in terms
of silver.” Under bimetallism two metallic standards operate simultaneously.
Two types of standard coins from two different metals (say gold and silver) are minted. Both
the types of standard coins become unlimited legal tender and a fixed ratio of exchange based
on mixed ratio of exchange based on mint parity is prescribed for them. Provisions for
unlimited purchase, sale and redeem-ability are extended to both metals.
Features of Bimetallism:

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(i) A bimetallic standard is based on two metals; it is the simultaneous maintenance of both
gold and silver standards.
(ii) There is free and unlimited coinage of both metals.
(iii) The mint ratio of the values of gold and silver at the mint is fixed by the government.
(iv) Two types of standard coins (i.e., gold coins and silver coins) are in circulation at the
same time.
(v) Both the coins are full-bodied coins. In other words, the face value and the intrinsic value
of both the coins are equal
(vi) Both the coins are unlimited legal tenders. They are also convertible into each other.
(vii) There is free import and export of both the metals.
Merits of Bimetallism:
The merits of bimetallism are discussed below:
i. Convenient Full-Bodied Currency:
Bimetallism provides convenient full-bodied coins for both large and small transactions. It
provides portable gold money for large transactions and convenient silver money for smaller
payments. This argument has, however, lost its force now when credit money has developed.
ii. Price Stability:
Under this monetary system, the shortage of one metal can be offset by increasing the output
of the other metal. Consequently, stability in the prices of both the metals and hence, in the
internal prices can be ensured.
iii. Exchange Rate Stability:
Bimetallism ensures stability of exchange rate. As long as gold and silver are stabilised in
terms of each other, the currencies of all countries with fixed values in gold or in silver would
exchange for each other at nearly constant rates.
iv. Sufficient Money Supply:
Under bimetallism, sufficient money supply is assured to meet the trade requirements of the
economy. Since there is no question of both metals becoming scarce simultaneously, money
supply is more elastic under this system.
v. Maintenance of Bank Reserves:
Under bimetallism, the maintenance of bank reserves becomes easy and economical. Under
this system, both gold and silver coins are standard coins and unlimited tender. Therefore, it
is easy for the banks to keep their cash reserves either in gold coins or in silver coins or in
both.
vi. Low Interest Rates:
Since, under bimetallism, money is made of two metals, its supply is generally more than its
demand. As a result, the interest rates decline. Banks can extend loans at cheaper rates. This
would increase investment and hence production in the economy.
vii. Stimulates Foreign Trade:
Bimetallism stimulates international trade in two ways, – (a) A country on bimetallism can
have trade relations with both gold standard and silver standard countries, (b) There are no
restrictions on imports and exports due to the free inflow of both types of coins.
Demerits of Bimetallism:
Bimetallism has the following demerits:
i. Operation of Gresham’s Law:
Bimetallism in a single country is a temporary and not workable monetary standard due to the
operation of Gresham’s law. According to this law, when there is a disparity between the
mint parity rate and the market rate of exchange of the two metals, bad money or the over-
valued metal at the mint (whose mint price exceeds market price) tends to drive out of
circulation good money or under-valued metal at the mint (whose market price exceeds mint
price).

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Thus, ultimately, single metal money (monometallism) will remain in practice. Thus, national
bimetallism is only a temporary phenomenon. Only international bimetallism can prove
permanent and practicable.
ii. Inequality between Mint and Market Rates:
Bimetallism can operate successfully only if the equality between the market rate and the
mint rate can be maintained. But, in practice, it is difficult to maintain equality between the
two rates, particularly when one metal is oversupplied than the other.
iii. No Price Stability:
The argument that bimetallism ensures internal price stability and there will be an automatic
adjustment between supply and demand for money is illusionary. There can be a possibility
of both the metals to become scarce.
iv. Payment Difficulties:
Bimetallism leads to difficult situation in the settlement of transactions when one party insists
on payment in terms of a particular type of coins.
v. Encourages Speculative Activity:
It encourages speculative activity in the two metals when their prices fluctuate in the market.
vi. No Stimulus to Foreign Trade:
International trade is stimulated if all the countries adopt bimetallism. But, this is a rare
possibility in the present circumstances.
vii. Costly Monetary Standard:
Bimetallism is a costly monetary standard and all nations, particularly the poor nations,
cannot afford to adopt it.
Gresham’s Law:
Gresham’s law in its simple form states that when good and bad money are together in
circulation as legal tender, bad money tends to drive good money out of circulation. This
implies that less valuable money tends to replace more valuable money in circulation.
This law was enunciated by Sir Thomas Gresham who was the financial adviser to Queen
Elizabeth I in the 16th century in England. Gresham was, however, not the first to develop
this law, but it became associated with his name after he explained a problem faced by the
Queen. With a view to reform the currency system, the Queen tried to replace bad coins of
the previous regime by issuing new full-weighted coins.
But to her surprise, as soon as new coins were circulated, they disappeared and the old
debased coins continued to remain in circulation. She sought the advice of Sir Thomas
Gresham, who provided his explanation in the form of the law which states- “Bad money
tends to drive out of circulation good money.”
The theoretical explanation of this law is in terms of the divergence of the market rate of
exchange of the two currencies from mint rate. If the mint rate (i.e., the official rate of
exchange between two types of money) differs from the market rate of exchange between the
two types of money, then the over-valued money at the mint will tend to drive the under-
valued money out of circulation.
Suppose under bimetallism, one gold coin exchanges for 10 silver coins, i.e., the official rate
of exchange or the mint rate is 1:10. Now, if the market rate is 1:12, then gold is under-
valued and silver is over-valued at the mint rate (i.e. the market rate of gold exceeds the mint
rate and the market rate of silver is less, than its mint rate). In this case, gold will become
good money and silver a bad money. The bad money (silver) will drive out good money
(gold) from circulation.
Operation of the Law:
When both good and bad money together are in circulation as legal tender, good money
disappears in three ways:
i. Good Money is Hoarded:

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When both good and bad money circulate simultaneously, people have the tendency to hoard
good money and use bad money for making payment.
ii. Good Money is Melted:
Since both good coins and bad coins are in circulation and have the same value, people prefer
to melt good coins to convert them into ornaments or other items of art.
iii. Good Money is Exported:
In payments to the foreign countries, gold coins are accepted by weight and not by counting.
Thus, it would be profitable to pay to the foreigners in terms of new full-weight coins rather
than old and light-weight coins.
Gresham’s Law in General Form:
Gresham’s law, in its original form, applies only to debased coins of monometallic system
(i.e., gold standard).
But, the law can, however, be extended to all forms of monetary standards:
1. Under Monometallism:
Under monometallism (for example gold standard), the old and worn out coins are regarded
as bad coins and full-weight coins are considered as good coins. According to Gresham’s
law, the old and worn out coins drive new and full- weight coins out of circulations.
2. Under Bimetallism:
Under bimetallism (generally a system of gold and silver coins), coins of overvalued metals
are considered bad money and coins of under-valued metal as good money. Thus, according
to Gresham’s law, the over-valued coins will drive under-valued coins out of circulation.
3. Under Paper Standard:
Under paper standard, if both standard coins of superior metal and inconvertible paper notes
are in circulation, the metallic coins will be good money and paper notes will be bad money.
Thus, paper notes will drive out standard coins from circulation.
Thus, Gresham’s law is a general law which can be applicable in different forms of monetary
standards. Marshall presented a generalized version of the law – “Gresham’s law is that an
inferior currency, if not limited in amount, will drive out the superior currency.”
Limitations of the Law:
Gresham’s law will operate if the following necessary conditions are satisfied.
In the absence of these conditions the law will fail to apply:
i. Usefulness of Good Money:
An important condition for Gresham’s law is that the intrinsically more valuable money (i.e.,
good money) must also be more valuable in other uses than it is as money in circulation. The
failure of this condition to apply explains why the coin currency today remains in circulation
as fairly as paper currency despite its higher intrinsic value.
ii. Fixed Parity Ratio:
The applicability of the law requires that the intrinsically more valuable money must be
relatively fixed by law in its parity with money. The law will not hold where one money
becomes intrinsically more valuable than another money (at the old parity) if the parity
changes.
iii. Sufficient Money Supply:
The law will operate only if both good money and bad money are in circulation and the total
money supply is more than the actual monetary requirements of the economy.
iv. Sufficient Supply of Bad Money:
The applicability of the law requires that there should be sufficient bad money in circulation
to meet the transactions requirement of the people. If there is scarcity of bad money, both
good and bad money will remain in circulation and the law will not operate.
v. Contents of Pure Metal:

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The law will not operate if the contents of pure metal in coins are less than that in the old
ones.
vi. Acceptability of Bad Money:
The law will operate if people are prepared to accept bad money in transactions.
vii. Distinction between Good Money and Bad Money:
The law assumes that people can distinguish between bad money and good money.
viii. Development of Banking Habit:
The law applies in the absence of banking habits. Development of banking habits among the
people tends to discourage hoarding and thus restricts the operation of Gresham’s law.
ix. Convertibility:
The law also does not operate if the country is on inconvertible paper standard.
B. Paper Standard:
Paper standard refers to a monetary standard in which inconvertible paper money circulates
as unlimited legal tender. Under paper money standard, although the standard money is made
of paper, both currency and coins serve as standard money for purpose of payment. No gold
reserves are required either to back domestic paper currency or to facilitate foreign payments.
The paper standard is known as managed standard because the quantity of money in
circulation is controlled and managed by the monetary authority with a view to maintain
stability in prices and incomes within the country. It is also called fiat standard because paper
money is inconvertible in gold and still regarded as full legal tender. After the general
breakdown of gold standard in 1931, almost all the countries of the world shifted to the paper
standard.
Features of Paper Standard:
The paper standard has the following features:
(i) Paper money (paper notes and token coins) circulates as standard money and accepted as
unlimited legal tender in the discharge of obligations.
(ii) The unit of money is not defined in terms of commodity.
(iii) The commodity value (or intrinsic value) of the circulating money is particularly nil.
(iv) Paper money is not convertible in any commodity or gold.
(v) The purchasing power of the monetary unit is not kept at par with any commodity (say
gold).
(vi) Paper standard is national in character. There is no link between the different paper
currency systems.
(vii) The foreign rate of exchange is determined on the basis of the parity of purchasing
powers of the currencies of different countries.
Merits of Paper Standard:
Various merits of paper standard are described below:
1. Economical:
Since under paper standard no gold coins are in circulation and no gold reserves are required
to back paper notes, it is the most economical form of monetary standard. Even the poor
countries can adopt it without any difficulty.
2. Proper Use of Gold:
Wastage of gold is avoided and this precious metal becomes available for industrial, art and
ornamental purpose.
3. Elastic Money Supply:
Since paper money is not linked with any metal, the government or the monetary authority
can easily change the money supply to meet the industrial and trade requirements of the
economy.
4. Ensures Full Employment and Economic Growth:

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Under paper standard, the government of a country is free to determine its monetary policy. It
regulates its money in such a way that ensures fall employment of the productive resources
and promotes economic growth.
5. Avoids Deflation:
Under paper standard, a country avoids deflationary fall in prices and incomes which is the
direct consequence of gold export. Such type of situation arises under gold standard when a
participating country experiences adverse balance of payments. This results in the outflow of
gold and contraction of money supply.
6. Useful during Emergency:
Paper currency is very useful in times of war when large funds are needed to finance war. It
is also best suited to the less developed countries like India. To these economies, it makes
available large amounts of financial resources through deficit financing for carrying out
developmental schemes.
7. Internal Price Stability:
Under this system, the monetary authority of a country can establish stability in the domestic
price level by regulating money supply in accordance with the changing requirements of the
economy.
8. Regulation of Exchange Rate:
Paper standard provides more effective and automatic regulation of exchange rate, whereas,
under gold standard, the exchange rate is absolutely fixed. Whenever, exchange rate
fluctuates as a result of disequilibrium between demand and supply forces, the paper standard
works on imports and exports and restores equilibrium. It allows the forces of demand and
supply to operate freely to establish equilibrium.
Demerits of Paper Standard:
The paper standard suffers from the following defects:
1. Exchange Instability:
Since the currency has no link with any metal under paper currency, there are wide
fluctuations in the foreign exchange rates. This adversely affects the country’s international
trade. Exchanging instability arises whenever external prices move more than domestic
prices.
2. Internal Price Instability:
Even the commonly claimed advantage of paper standard, i.e., domestic price stability, may
not be achieved in reality. In fact, the countries now on paper standard experience such
violent fluctuations in internal prices as they experienced under gold standard before.
3. Dangers of Inflation:
Paper standard has a definite bias towards inflation because there is always a possibility of
over- issue of currency. The government under paper standard generally has a tendency to
use managed currency to cover up its budget deficit. This results in inflationary rise in prices
with all its evil effects.
4. Dangers of Mismanagement:
Paper currency system can serve the country only if it is properly and efficiently managed.
Even the minor mistake in the management of paper currency can bring such disastrous result
that cannot be conceived of in any other form of monetary standard. If the government issues
little more or little less currency than what is required for maintaining price stability, it may
lead to cumulative inflation or cumulative deflation.
5. Limited Freedom:
In the present world of economic dependence, it is almost impossible for a particular country
to isolate itself and remain unaffected from the international economic fluctuations simply by
adopting paper standard.
6. Absence of Automatic Working:

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The paper standard does not function automatically. To make it work properly, the
government has to interfere from time to time.
Principles of Note Issue:
At present, all the countries of the world have adopted paper standard.
In fact this standard has proved a boon to the modern monetary system. The central bank of a
country, which plays an important role in the paper standard, is assigned the job of note issue.
A good note issue system should possess the following qualities:
(a) It should inspire public confidence, and, for this, it must be based on sufficient reserves of
gold and silver.
(b) It should be elastic in the sense that money supply can be increased or decreased in
accordance with the needs of the country.
(c) It should be automatic and secure.
To ensure a good note issue system, two principles of note issue have been advocated:
(1) Currency principle and
(2) Banking principle.
1. Currency Principle:
The currency principle is advocated by the ‘currency school’ comprising Robert Torrens,
Lord Overstone, G. W. Norman and William Ward. Currency principle is based on the
assumption that a sound system of note issue should command the greatest public confidence.
This requires that the note issue should be backed by 100 per cent gold or silver reserves. Or
in other words, paper currency should be fully convertible into gold or silver.
Thus, according to the currency principle, the supply of paper currency is subjected to the
availability of metallic reserves and varies directly with the variations in the metallic
reserves.
Merits:
The currency principle has the following advantages:
(i) Since, according to this principle, the paper currency is fully convertible into gold and
silver, it inspires maximum confidence of the public.
(ii) There is no danger of note issue of the paper currency leading to the inflationary
pressures,
(iii) It makes the paper currency system automatic and leaves nothing to the will of the
monetary authority.
Demerits:
The currency principle has the following drawbacks:
(i) The currency principle makes the monetary system inelastic because it does not allow the
monetary authority to expand the money supply according to the needs of the country.
(ii) It requires full backing of gold reserves for note issue. Thus, it makes the monetary
system expensive and uneconomical.
(iii) This principle is not practical for all countries because gold and silver are unevenly
distributed among countries.
2. Banking Principle:
The banking principle is advocated by the ‘banking school’, the important members of which
are Thomas Tooke, John Fullarton James, Wilson and J.W. Gilbart. The banking principle is
based on the assumption that the common man is not much interested in getting his currency
notes converted into gold or silver.
Therefore 100 per cent metallic reserves may not be necessary against note issue. It is
sufficient to keep only a certain percentage of total paper currency in the form of gold or
silver reserves. The banking principle of note issue is derived from the practice of the
commercial banks to keep only a certain proportion of cash reserves against their total
deposits.

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Merits:
The following are the merits of banking principle:
(i) The banking principle renders note issue system elastic. The monetary authority can
change the supply of currency according to the needs of the economy.
(ii) Since the banking principle does not require 100 percent metallic backing against the note
issue, it is the most economic principle and thus can be followed by both rich and poor
countries.
Demerits:
The banking principle has the following demerits:
(i) The banking principle is inflationary in nature, because it involves the danger of over-
issue of paper currency.
(ii) The monetary system based on the banking principle does not command public
confidence because the system is not fully backed by metallic reserves.
Conclusion:
The main conclusion regarding the two principle of note issue is:
(i) Both the currency principle and the banking principle fail to satisfy all the, requirements of
a good note issue system. The currency principle ensures security and public confidence, but
it lacks elasticity, economy and practicability. On the contrary, the banking principle provides
elasticity and economy to the note issue system, but it suffers from the drawbacks of over-
issue and loss of public confidence.
(ii) Despite the incompleteness of both the principles, the banking principle, rather than the
currency principle, has been preferred and widely accepted in the modern times mainly
because of its emphasis on the qualities of elasticity, economy and practicability of the note
issue system. The quality of convertibility, which is basic to the currency principle, is no
longer considered as necessary requirement for a good note issue system.
Methods of Note Issue:
Different countries have adopted various methods of note-issue in different periods.
Important methods of note-issue are discussed below:
1. Simple Deposit System:
Under the simple deposit system, the paper currency notes are fully backed by the reserves of
gold or silver or both. This system is based on the currency principle of note issue. This
method involves no danger of over-issue of currency and commands maximum degree of
public confidence. But, this system has never been practised because it is very costly and has
no elasticity of money supply.
2. Fixed Fiduciary System:
Under the fixed fiduciary system, the central bank is authorised to issue only a fixed amount
of currency notes against government securities. All notes issued in excess of this limit
should be fully backed by gold and silver reserves. Fiduciary issue means the issue of
currency notes without the backing of gold and silver. This system was first introduced in
England under the Bank Charter Act of 1844 and still prevails there. India followed this
system between 1862 to 1920.
Merits:
Fixed fiduciary system has the following advantages:
(i) It ensure convertibility of currency notes.
(ii) It inspires public confidence since the government guarantees the convertibility of notes.
(iii) There is no danger of over-issue of paper notes because barring a certain portion, the
entire note issue is backed by gold reserves.
Demerits:
The main disadvantages of the fixed fiduciary system are:

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(i) It makes the monetary system less elastic. In times of economic crises, money supply
cannot be increased without keeping additional gold in reserve.
(ii) It is a costly system which requires sufficient gold reserves. Poor countries cannot afford
to adopt it.
(iii) It is inconvenient method because whenever gold reserves fall, the central bank has to
reduce the supply of currency which greatly disturbs the functioning of the economy.
3. Proportional Reserves System:
Under the proportional reserve system, certain proportion of currency notes (40%) are backed
by gold and silver reserves and the remaining part of the note issue by approved securities.
India adopted this method on the recommendation of Wilton Young Commission.
According to the Reserve Bank of India Act 1933, not less than 40 per cent of the total assets
of the Issue Department should consist of gold bullion, gold coins and foreign securities, with
the additional provision that gold coins and gold bullion were not at any time to be less than
Rs. 40 crores. The proportional reserve system was later replaced by the minimum reserve
system by the Reserve Bank of India (Amendment) Act, 1956.
Merits:
The proportional reserve system has the following advantages:
(i) It guarantees convertibility of paper currency.
(ii) It ensures elasticity in the monetary system; the monetary authority can issue paper
currency much more than that warranted by reserves.
(iii) It is economical and can be easily adopted by the poor countries.
Demerits:
The proportional reserves system suffers from the following defects:
(i) Under this system, it is easy to expand currency but very difficult to reduce it. The
reduction of currency has deflationary effects in the economy.
(ii) There is wastage of gold because large amount of gold lies in the reserve and cannot be
put to productive use.
(iii) The convertibility of paper notes is not real. In practice, high denomination notes are
converted into low denomination notes and not into coins.
4. Minimum Fiduciary System:
Under the minimum fiduciary system, the minimum reserves of gold against note issue that
the authority is required to maintain are fixed by law. Against these minimum reserves, the
monetary authority can issue as much paper currency as is considered necessary for the
economy. There is no upper limit fixed for the issue of currency.
Minimum fiduciary system is based upon two considerations:
(a) The central bank feels that there should not be any restriction on the note issue, especially
when the demand for currency is fast increasing,
(b) In the modern age, when bank deposits assume greater significance as an important
constituent of money supply, the convertibility of notes into gold need not be bothered about.
The minimum fiduciary system, if ably managed, can prove very useful for developing
countries. It can make available enormous resources for financing developmental schemes.
Similarly, during inflation, the monetary authority can control the money supply. This system
has been in force in India since 1957. The Reserve Bank of India is required to keep
minimum reserves of Rs. 200 crores of which not less than Rs. 115 crores must be kept in the
form of gold.
Merits:
The minimum reserve system has the following advantages:
(i) The system is economical because the entire note issue need not be backed by metallic
reserves. Only a minimum reserve is to be maintained.

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(ii) It renders elasticity to the monetary system. After maintaining the minimum reserves, the
monetary authority can issue any amount of currency that it feels necessary.
Demerits:
The minimum reserve system has the following drawbacks:
(i) Since, under this system, no additional reserves are required for increasing the supply of
currency, there is always a tendency towards the over-issue of currency, and hence an
inherent danger of inflationary pressures.
(ii) Since the system provides no convertibility of currency notes into gold, it lacks public
confidence.
5. Maximum Reserve System:
Under this system, the government fixes the maximum limit upto which the monetary
authority can issue notes without the backing of metallic reserves. The monetary authority
cannot issue notes beyond this limit. The maximum limit is not rigid and may be revised from
time to time according to the changing needs of the economy.
This system was followed by France and England upto 1928 and 1939 respectively. Under
this system, the Central bank is given the power to determine the maximum limit and thus an
element of elasticity is introduced in the system of note issue. The system, however involves
the dangers of over-issue and loss of public confidence when the maximum limit is raised and
additional currency is circulated without the backing of metallic reserves.
Conclusion:
The following conclusions emerge from the discussion of various methods of note issue:
(i) The analysis of relative merits and demerits of various methods of note issue makes it
difficult to identify any one method as an ideal method.
(ii) A good method of note issue must possess the qualities of economy, elasticity and public
confidence without being inflationary in effect.
(iii) Convertibility of currency notes into some precious metal is no longer considered an
important requirement because in modern times currency notes are accepted on their own
merit.
(iv) Keeping in view these considerations, minimum fiduciary system can prove to be a better
method, if managed ably and sincerely.
Ideal Monetary System:
An ideal monetary standard should be able to achieve the twin objectives of – (a) growth and
full employment with reasonable price stability within the country, and (b) smooth flow of
goods, services and capital at the international level. Such an ideal monetary system requires
wise blending of both paper and gold standards. This blending will provide the advantages of
both the standards, with none of their disadvantages.
In modern times, the establishment of International Monetary Fund (IMF) and the
International Bank of Reconstruction and Development (IBRD) has been designed to give the
ideal monetary system a practical shape. These institutions have been able – (a) to make the
paper standard function efficiently both internally and internationally by removing its various
defects; and (b) to operate international affairs quite successfully, thus promoting trade and
cooperation among the nations.
1.4. DETERMINATION OF MONEY SUPPLY AND CREDIT
CREATION
It will be seen that the most important function of a commercial bank is the creation of credit
money—a function which overshadows all other banking functions.
Credit creation or money creation refers to the power of the banks to expand or contract
demand deposits through the process of more loans, advances and investments.
Some writers express the view that a bank could never lend more than the amount deposited
by the depositors; this may be partially true.

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But it is also true that whatever is left out by a bank may come back by way of new deposits,
which may be lent out again and so on, a deposit becoming a loan which again returns to the
bank as a deposit and becomes the basis for a new loan and so on.
A commercial bank, therefore, has been aptly described as a ‘factory of credit’, which is able
to multiply loans and investments and hence deposits. With a little cash at the disposal they
are able to create additional purchasing power to a considerable degree. It is in this sense that
banks create credit. An increase in bank credit will, therefore, mean multiplication of bank
deposits.
There are mainly two ways of creating credit money by a commercial bank:
(a) By giving a loan, and
(b) By purchase of securities.
(a) By giving a loan:
Let us assume an isolated community having no foreign trade relations and only one bank
where everybody keeps an account; further no cash circulates and transactions are settled by
cheques. Bankers know that all the currency that depositors withdraw soon returns to the
bank. They also know that all depositors will not withdraw all deposits at the same time.
From experience they have learnt that if they just keep about 20% of their total demand
deposits in cash reserves, they will have enough to meet all demands for cash.
Suppose an ordinary borrower goes to the bank for a loan of Rs. 1,000. After being convinced
of the solvency of the borrower and the safety of the loan in his hands, the bank will advance
a loan of Rs. 1,000 not by handing over cash or gold to the borrower, but by opening an
account in his name. If the borrower, already has an account, he will be allowed an overdraft
to the extent of Rs. 1,000.
Thus, the most usual method of making a loan is merely to credit the account of the borrower
with Rs. 1,000. The borrower will then draw cheques on the bank while making purchases.
Those who receive the cheques deposit them with the banks in their own accounts. Therefore,
a bank loan of Rs. 1,000 has resulted in deposits of Rs. 1,000. The point to be noted and
understand is that loans are made by creating a deposit.
When a person deposits Rs. 1,000 with a bank, the bank does not keep the entire cash but
only a certain percentage (say 20%) of it to meet the day-to-day cash obligations. Thus, the
bank keeps Rs. 200 and lends to another person B, Rs. 800 by opening a credit account in his
name. Again, keeping 20% to meet B’s obligations, the bank advances the rest Rs. 640 to C ;
further keeping 20% to meet C’s obligations the bank advances Rs. 512 to D and so on, till
Rs. 1,000 are completely exhausted.
Thus, an original deposit of Rs. 1,000 leads to additional deposits of Rs. 800 plus Rs. 640
plus Rs. 512 plus Rs. 409, plus Rs. 328 and so on. By adding up all the deposits we get total
Rs. 5,000. It is clear, therefore, that the total amount of credit creation will be the reverse of
the cash reserve ratio. Here cash reserve ratio has been assumed to be 20% or 1/2, therefore,
the credit is Rs. 5,000 i.e., live times the original deposit of Rs. 1,000. Although, we have
assumed one bank, yet the credit creation will take place when there are many banks.
It is clear that the main limitation on credit creation is the reserve ratio of cash to credit.
Therefore, the amount of credit that a system of banking can create depends upon the reserve
ratio. The banks can multiply a given amount of cash to many times of credit. If the public
would demand no cash, credit would go on expanding indefinitely. But the reserve ratio is a
sort of leakage from the Stream of credit creation.
We can, thus, think of a credit creation multiplier. The higher the reserve ratio, the smaller is
the credit creation multiplier. In our example above, with an original deposit of Rs. 1,000 the
bank was in a position to create credit of Rs. 5,000. The credit creation multiplier is
obviously 5(Rs 5,000/Rs,1,000).

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In general, the credit creation multiplier is related to the reserve ratio in the following
way:
1/1-(1-reserve ratio) = 1/reserve ratio
If the reserve ratio is 1/3, credit creation multiplier is 3 a reserve ratio of 1/5 will give us a
higher value 5.
(b) By purchase of securities:
Making loan is not the only way in which deposits can be created. Sometimes, banks buy
securities at the Stock Exchange and also buy real assets. When the bank does so, it does not
pay the sellers in cash, rather it credits the amount of the price of the security or assets to the
accounts of the sellers. The bank, therefore, creates a deposit with it.
It does not matter whether the seller of securities or property is a customer of the purchasing
bank or not, as the seller is bound to deposit the cheques he receives in one of the banks. The
purchase of security by any banker is bound to increase the deposits either of his own bank or
of some other bank, in any case, the deposits of the banking system as a whole.
Multiple Credit or Money Expansion:
This process can also be shown in ‘T’ form. Suppose Mr. Z, who is a government employee
gets his pay cheque of Rs. 100. The cheque is used by the government is drawn on R.B. of
India. Let us assume Mr. Z has an account in Bank ‘A’ in which he deposits the cheque. Bank
‘A’ presents this cheque to RBI for collection, as a result of which, the deposits of Bank ‘A’
increase by Rs. 100 and its cash will also increase by Rs. 100.
The balance sheet of Bank ‘A’ (in T form) will be as follows:

By experience Bank A finds that Z will need hardly 10% of it in cash. It means Bank ‘A’ can
lend Rs. 90%, The bank ‘A’ grants a loan? What happens? It does not take out cash and give
it to the borrower. It either allows the Borrower (X) to overdraw his account (if he has one
with the bank) or it (Bank A) opens an account in his name to the extent of loan taken (Rs.
90), if he is a new customer. Let us say Bank ‘A’ grants a loan to X by opening an account in
his favour.
The balance sheet of Bank ‘A’ will appear as follows:

This is only a temporary phase because no one borrows from a bank merely to open an
account or maintain it, one borrows to utilise the money. Let X who has borrowed Rs. 90
issues a cheque of Rs. 90 to R from whom he has purchased goods. Let R deposits the cheque
in his account with bank ‘B’.
As such the balance sheet of Bank ‘A’ and ‘B’ will appear as follows:

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Cash of Bank ‘B’ increases because it has collected from Bank ‘A’. The total deposits in the
banking system now are Rs. 190. Bank ‘B’ further behaves in the same way as bank ‘A’
above, i.e., keeping 10% of the deposits in cash to meet the requirements of the depositors.
He may further grant a loan of Rs. 81 of the borrower of Bank ‘B’ draws a cheque of Rs. 81
and thus cheque is deposited with Bank *C’, the cash of Bank ‘B’ will go down by Rs. 81
and that of Bank ‘C’ will go up by Rs. 81.
The balance sheets of Banks A, B, C, will appear as follows:

Thus, at each successive stage every bank which receives deposits from the previous
bank will be able to lend 90% of the deposits—showing the process as follows:
100 + 90 + 81 + 72.90 +………
This is geometric series and the sum will be 100/0.10 = 1.000.
Thus, with an initial deposit of Rs. 100 the banking system has been able to create total credit
of Rs. 1,000 i.e., ten times more than the original deposits. It is to be understood that it is not
only the individual bank that creates credit many times the original deposit, but also the
banking system as a whole can create derivative deposits up to several times the amount of an
original addition to its cash holdings. Primary deposits, as we know arise from the actual
deposits of cash in a bank.
However, the bank can create deposits actively by creating claims against itself in favour of a
borrower or of a seller of securities or of property acquired by the bank. These actively
created deposits are derivative deposits, which arise from loans or securities purchased or
primary deposits created.
An individual bank, when it creates derivative deposits, loses cash to other hanks; this
transfer of cash within the banking system creates, in turn, primary deposits, enhancing the
possibility for a further creation of derivative deposit, by the banks receiving the cash. This
process of the commercial banking system to expand credit many times more the initial
excess reserves is called the multiple credit creation. For example, let us suppose that Rs. 100
of excess reserve in Bank ‘A’ enable the creation of Rs. 100 of derivative deposits through
the extension of loans to borrowers.

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The borrowers make payments of Rs. 100 by cheques to customers of Bank ‘B’ resulting in a
creation of Rs. 100 of primary deposits in Bank ‘B’. Assuming the customary cash reserve
ratio to be 10%, the excess reserve of Bank ‘B’ and, therefore, the amount of derivative
deposit is Rs. 90. Further, the payments of cheques by borrowers from Bank ‘B’ to customers
of Bank ‘C’ create Rs. 90 of primary deposits in Bank ‘C’ and lead to excess reserves and
derivative deposits of Rs. 81 in Bank ‘C’ etc. until the original Rs. 100 of excess reserves are
diffused among many banks resulting in a multiple expansion of derivative deposits of Rs.
1,000 (Derivative deposits of Rs. 100 + 90 + 81 … + n = 1,000 or 10 times the original
excess reserves of 100, given a 10% reserve ratio). Algebraically Rs. 100 + Rs. 100 ( 9/10) +
Rs. 100 (9/10)2… + Rs. 100 (9/10)n. It is the sum of geometric progression a + ar + ar 2… + arn ,
where, n = (n; tends to infinity or 1/1-r. In our example r = 9/10 or 90% and a = Rs. 100.
By substituting these values, we get:

Destruction of Bank Credit or Money:

Banks destroy credit as easily as they create it. Bank credit can be destroyed by means of a
reduction in bank loans and investment. The extent of the destruction depends upon the
prevailing cash reserve ratio. A reduction of cash below the reserves to support demand
deposits leads to multiple contraction of bank credit throughout the banking system. Thus, in
the previous example, the original reduction of Rs. 1,000 in Bank ‘A’, is followed by a
reduction of deposits of Rs. 800 from Bank ‘B’, of Rs. 640 from Bank ‘C’ and so on.
The process of contraction of bank credit is the same as that of expansion—only in the
reverse direction. The credit creation multiplier process works as easily in the backward
direction. It may be mentioned that sometimes the government intervenes directly with the
creation and destruction of money (by commercial banks). Under normal circumstances
government need not interfere but in the overall interest of economic stability, to avoid both
inflation or deflation, the government may create or destroy money.
It is in this sense that money is described as ‘a creature of the state’. The government may
intervene by creating and destroying the legal tender, resorting to printing press, monetary
management through treasury, demonetization, etc. Out of the various tools to create or
destroy money, the choice of any particular tool will depend on the nature of the situation,
objectives of monetary policy, monetary and banking convention, etc.
The Supply of Bank Deposits and Fractional Reserve System:
The traditional approach for the determination of the volume of bank deposits is modified by
an alternative approach. Bankers have always made out a case that they lend only the deposits
they receive (or out of it). Thus, their ability to attract deposits is the chief constraint on their
work. Economists, on the other hand, assert that bank lending itself creates deposits.
Economists say bank deposits result or arise because of bank lending and not because lending
is done because bank deposits are received. Bank deposits do not constitute a precondition for
lending.
If a banking system works to a minimum ratio of reserves in this case cash to deposit
liabilities— we say it is a fractional reserve system. Thus, so far fractional reserve system has
been based on fixed cash reserve ratio. But this system is by no means confined to cash—this
system could exist whenever banks maintain a fixed ratio of some asset or group of asset
‘reserves’—to other deposits liabilities— because a change in their holdings of the specified
assets would be associated with a proportionate change in their deposits.
In other words, the new theory amounts to the fact that bank deposits bear a given relation to
the bank reserves and a change in the reserve base (which includes cash plus assets of various
types) will lead to a multiple change in bank deposits.

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It is, therefore, essential to study the factors which determine the supply of reserves. If banks
are adhere to a fixed reserve ratio and if the supply of reserves is determined without any
reference to the level of bank deposits, then it is reasonable to regard reserves as a proximate
cause in the determination of bank deposits. But it the supply of reserves is determined by the
level of bank deposits, rather than the other way round, we must look beyond reserves to
some other explanation of changes in deposits.
Liquidity Ratio Theory:
The concept of multiple expansion of bank deposits is not restricted to the case in which the
basis for expansion is a change in the banking system’s holding of cash. If it could be shown
that the authorities controlled the supply of some other collections of assets held by the
banks, and if the banks maintain a fixed proportion of these assets in their port-folios, then
this particular collection of assets would form the base of a fractional reserve system and
changes in the bank’s holdings of these assets would generate multiple changes in bank
deposits (and hence the money supply). After 1950s it appeared that the collection of assets
held as liquid assets by the London clearing banks filled this role.
However, the theory of ‘liquid asset’ as basis of credit expansions has proved to be deficient
in several respects, inasmuch as there are questions relating to the control of the liquid assets
base—the extent to which such assets are held outside banks and the influences determining
fluctuations in these holdings—the extent to which banks themselves can influence the
supply of liquid assets. Further, the rigidity of the liquidity ratio has been questioned.
Do the banks really conform to a more or less fixed liquid assets ratio? Will a redistribution
of deposits between the banks with high and with low liquidity ratios frustrate any attempt by
the authorities to control bank lending by contracting the liquidity base ‘? Thus, we find that
the liquidity ratio theory is defective or at best incomplete as an explanation of short-term
changes in the level of bank deposits in the UK—at least it needs to be supplemented by a
theory explaining the total amount of short-term government debt held by the private sector.
This, however, does not mean that the theory could not be used to explain long-term trends in
bank deposits.
Despite the shortcomings, the method of variations in reserve requirements relating them to
the holdings of liquid assets (liquidity ratio approach) has definitely some advantages over
the alternative device of fixing and varying the cash ratio. Like the cash ratio, the liquid
assets ratio does not penalize the profit earning capacity of the banks. Newlyn, a monetary
expert has strongly argued the case of a variable liquid assets ratio. Although the debate
whether the variable liquid assets ratio is superior to the cash ratio as an effective means of
credit control still continues ; it is, however, clear that in future the liquidity ratio theory may
become more important in explaining movements in clearing bank deposits.
Further, the liquidity ratio theory breaks down because the changes in the liquid assets base
of the banking sector as a whole will not cause the corresponding changes in bank deposits if
they are accompanied by the changes in the distribution of deposits between banks which
maintain low and banks which maintain high liquidity ratios. In conclusion, therefore, it may
be said that the liquidity ratio theory of the determination of the volume of bank deposits in
the UK is no more satisfactory than the cash ratio theory.
Government:
Government is another source through which significant variations or changes in money
supply take place in a country. As the government have assumed many development and
welfare functions—they bring about changes in money supply by various direct and indirect
ways. Firstly, the government has the monopoly to issue money (notes and coins) and it has
the power to destroy the same (sometimes suddenly, like demonetization of higher
denomination notes) in extreme circumstances.

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Similarly, the governments may and do resort to printing more money in times of financial
needs. Such a method of bringing about changes in money supply is highly inflationary and
should be resorted to sparingly. Secondly, the government may borrow from the Central
Bank (out of its idle reserves) or from commercial banks (out of their time deposits).
The amount so borrowed soon finds a way out in circulation on account of the purchases
made by the government of services and materials from individuals, firms or institutions.
This brings, in turn, a net change (addition) to the supply of money. Thirdly, the budgetary
operations of the government also have an impact on the money supply.
When there is a budget surplus showing an increase in the government deposits, there is a
corresponding decline in the money supply. The government may hold this surplus (idle
balances) continuously or it may use these balances to repay the outstanding debts. If the
balances are held indefinitely, there will be net decrease in the money supply which may
induce further secondary declines in the supply of money.
Similarly, in the second case the effects of-money supply will depend on whether the
government pays back debts held by the central bank or debts held by the general public.
Again, in case of a deficit the effect on money supply will depend on whether it is financed
by a resort to the printing press or by borrowing from public or from the central bank. Except
in the second case of borrowing from public, financing the deficit will make a net addition to
the money supply.
Central Bank:
Central Bank is the most important institution and source of money supply because it has got
the monopoly of issuing notes. The Central Bank can bring about variations in money supply
by changing bank rate, by open market operations, by changing cash reserve ratios of
commercial bank etc.

1.5 MONEY MULTIPLIER AND RESERVE RATIO

The Money Multiplier refers to how an initial deposit can lead to a bigger final increase in
the total money supply.
For example, if the commercial banks gain deposits of £1 million and this leads to a final
money supply of £10 million. The money multiplier is 10.
The money multiplier is a key element of the fractional banking system.
1. There is an initial increase in bank deposits (monetary base)
2. The bank holds a fraction of this deposit in reserves and then lends out the rest.
3. This bank loan will, in turn, be re-deposited in banks allowing a further increase in
bank lending and a further increase in the money supply.
The Reserve Ratio
The reserve ratio is the % of deposits that banks keep in liquid reserves.
For example 10% or 20%
Formula for money multiplier

In theory, we can predict the size of the money multiplier by knowing the reserve ratio.
 If you had a reserve ratio of 5%. You would expect a money multiplier of 1/0.05 = 20
 This is because if you have deposits of £1 million and a reserve ratio of 5%. You can
effectively lend out £20 million.
Example of money multiplier
 Suppose banks keep a reserve ratio of 10%. (0.1)

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 Therefore, if someone deposits $100, the bank will keep $10 as reserves and lend out
$90.
 However, because $90 has been lent out – other banks will see future deposits of $90.
 Therefore, the process of lending out deposits can start again.

Note: This example stops at stage 10. In theory, the process can continue for a long time until
deposits are fractionally very small.

 If allowed to repeat for an infinite number of times, the final total deposits would be
$1,000
 Money multiplier = 1/0.1 = 10.
 Final increase in money supply = 10 x $100 = $1,000
Using the Reserve ratio to influence monetary policy
In theory, if a Central Bank demands a higher reserve ratio – it should have the effect of
acting like deflationary monetary policy. A higher reserve ratio should reduce bank lending
and therefore reduce the money supply.
Money Multiplier in the real world
In a simple theory of the money multiplier, it is assumed that if the bank lends $90 – all of
this will return. However, in the real world, there are many reasons why the actual money
multiplier is significantly smaller than the theoretically possible money multiplier.
1. Import spending. If consumers buy imports the money leaves the economy
2. Taxes. A percentage of income will be taken in taxes.
3. Savings. Not all money is spent and circulated, a significant percentage will be saved

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4. Currency Drain Ratio. This is the % of banknotes that individual consumers keep in
cash, rather than depositing in banks. If consumers deposited all their cash in banks,
there would be a bigger money multiplier. But, if people keep funds in cash then the
banks cannot lend more
5. Bad loans. A bank may lend out $90 but the company goes bankrupt and so this is
never deposited bank into the banking system.
6. Safety reserve ratio. This is the % of deposits a bank may like to keep above the
statutory reserve ratio. i.e. the required reserve ratio may be 5%, but banks may like to
keep 5.2%.
7. It might not be possible to lend more money out. Just because banks could lend
95% of their deposits doesn’t mean they can, even if they wanted to. In a recession,
people may not want to borrow, but they prefer to save.
8. Banks may not want to lend Also, at various times, the banks may not want to lend,
e.g. during a recession they feel firms and individuals more likely to default.
Therefore, the banks end up with a higher reserve ratio.
Therefore, due to these factors, the reserve ratio and money multiplier are theoretical.
Loan first multiplier
The money multiplier model suggests banks wait for deposit and then lend out a fraction.
However, in the real world, banks may take it upon themselves to issue a loan, and then seek
out reserves from other financial institutions/Central Bank or private individuals.
For example, in the credit bubble of 2000-2007, many banks were lending mortgages by
borrowing on short-term money markets. They were lending money that wasn’t related to
saving deposit accounts.
Money multiplier and quantitative easing

In 2009-12 Central Banks pursued quantitative easing. This involves increasing the monetary
base. – Buying bonds off banks gave them greater cash reserves. In theory, this increase in
the money multiplier should increase the overall money supply by a large amount due to the
money multiplier

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However, in practice, this didn’t occur. The money supply didn’t increase because banks
were not keen to lend any extra money.
Also, banks were trying to improve their reserves following the credit crunch and their
previous over-extension of loans.

Reference:
https://www.economicshelp.org/blog/67/money/money-multiplier-and-reserve-ratio-in-
us/#:~:text=The%20Money%20Multiplier%20refers%20to,The%20money%20multiplier%2
0is%2010.
https://www.economicsdiscussion.net/money-supply/commercial-banks/money-supply-and-
credit-creation-by-commercial-
banks/8057#:~:text=Credit%20creation%20or%20money%20creation,more%20loans%2C%
20advances%20and%20investments.&text=Some%20writers%20express%20the%20view,thi
s%20may%20be%20partially%20true.
https://www.economicsdiscussion.net/monetary-standards/types-of-monetary-standards-
metallic-and-paper-standard-economics/31186
https://www.economicsdiscussion.net/money/economy-money/money-and-the-smooth-
working-of-the-economy/8029
https://www.yourarticlelibrary.com/economics/money/classification-of-money-full-bodied-
representative-full-bodied-and-credit-
money/30308#:~:text=Some%20of%20the%20major%20leads,of%20money%20as%20a%2
0commodity.

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